Corporate America has just enjoyed a bumper earnings season. Profits have risen by a quarter over the last year, underpinned by record high-profit margins. However, stock prices barely budged during earnings season, and some investors are concerned that increasingly high profit margins are just not sustainable.
There has been much focus on the warning from Jim Umpleby, chief executive of manufacturing giant Caterpillar, that the first quarter of 2018 might prove to be a "high watermark" for the company. The first quarter was an "exceptional quarter for performance", said Caterpillar, which surpassed analyst estimates last month as well as raising guidance for full-year profits.
Nevertheless, shares dropped after Caterpillar stressed it expected to face increased pricing pressures as the year progressed, with investors fretting this might be as good as it gets for profit margins. While Caterpillar has long been regarded as a bellwether for global economic activity, its comments may well reflect company-specific concerns. That said, it’s clear that profit margins are at especially lofty levels. Net profit margins for S&P 500 companies topped 11 per cent in the first quarter, according to FactSet – the highest figure since the firm began tracking the data in 2008. Eight of the 10 S&P 500 sectors reported net profit margins that are above their five-year averages.
Record profits
The corporate tax cut passed by the Trump administration has juiced profits, although margins have been elevated for some years now. In fact, first-quarter profit margins were at record levels even if one adjusts for the effects of the tax cut, according to Deutsche Bank data. Market bears have long argued that abnormally elevated profit margins cannot persist indefinitely, the main theory being that high profits should attract competition which ultimately results in margins reverting to historical norms. Accordingly, profit margins “are probably the most mean-reverting series in finance”, as
GMO
fund manager
Jeremy Grantham
has argued. “If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” However, bulls like to point out they’ve been hearing this argument for most of the current bull market. As far back as 2012, Grantham’s GMO colleague, the high-profile market strategist
James Montier
, warned that profit margins were “freakish”, adding that “what goes up must come down”. That hasn’t happened. Net profit margins have historically averaged around 6 per cent, but double-digit profit margins have been sustained for some time now.
Bears continue to see this as a temporary phenomenon, one that has been sustained by factors such as rock bottom interest rates and flat labour costs. However, bulls argue this time really is different, that profit margins have risen to a permanently higher plateau due to structural changes. Morgan Stanley, for example, has pointed out that, even during the severe market downturns in 2001 and 2008, profit margins for the largest US companies were well above the highest margins achieved during the 1974-94 period – a “powerful indication” that margins are unlikely to revert to previously longstanding historical norms.
Is this time different?
The fact that margins have remained so high for so long has caused Grantham to have second thoughts as to whether this time really might be different. Earlier this year, he acknowledged that the US economy and stock market is now increasingly dominated by the technology and service sectors, which are “inherently more profitable” than the manufacturing giants of old.
Compared to the industrial behemoths of yesteryear, highly profitable technology companies don't have the same need to invest in expensive plants and factories. Furthermore, businesses such as Apple and Google have built "incredibly strong, near-monopolistic franchises that should translate to higher margins", admitted Grantham. In a client letter last year, he noted that margins have risen by approximately 30 per cent compared to the pre-1997 era – a "large and sustained change".
The growth of the service and technology sectors are not the only drivers. Increased globalisation has increased the value of brands, much to the benefit of top US names such as Apple, Amazon and Facebook. Importantly, "steadily increasing corporate power" has been perhaps the "defining feature" of US politics in recent decades (a point evidenced by the make-up of the current US administration, which contains bankers and billionaires aplenty).
Grantham argues that “a flowering of corporatism” has maximised opportunities for influential large-cap companies and sectors that spend a lot of money lobbying. Paradoxically, he suggests that increased regulation over the last five decades may also have boosted the profitability of major corporations. All companies are financially affected by increased regulations but the biggest are better able to manage the costs, resulting in industries becoming increasingly concentrated and monopolistic.
This increased concentration is reflected in Credit Suisse data showing that the number of publicly traded US companies has halved over the last two decades. Corporate power might yet weaken for any number of reasons, but it is, says Grantham, unlikely to be quick enough to drag profits margins back to historical norms over the next 10 or 15 years.
Contraction
Certainly, the longer margins stay in elevated territory, the harder it becomes to argue that margins will revert to the lower levels of yesteryear. Still, some contraction in margins is certainly possible. S&P 500 earnings have soared 26 per cent over the last year, 10 times greater than the 2.6 per cent growth in average hourly earnings.
"Companies and shareholders have been taking a bigger and bigger share of the pie at the expense of labour," says Rob Arnott, who helps manage $205 billion at Research Affiliates. "That can't last." Arnott predicts that workers will benefit as wages and other factors normalise, resulting in earnings growth being smaller than economic growth over the next decade. Additionally, while structural changes may have boosted margins, they cannot continue to expand indefinitely. Over the last three years, average profit margins in the technology sector have soared from 15.9 per cent to more than 20 per cent, and it would be prudent to assume the sector cannot continue to post record margins in quarter after quarter. Still, Fundstrat head of research Thomas Lee notes that margins are at or near record highs in only four of the S&P 500's 11 sectors – technology, utilities, real estate, and consumer discretionary – indicating the overall expansion in profit margins has further room to run. His bullishness is shared by many analysts.
According to FactSet data, analysts expect net profit margins to continue to expand as 2018 progresses, topping 11.5 per cent in each of the following threequarters. In other words, US corporate profit margins may well contract in time – just not yet.
